Sustainable finance Bert d’Espallier

Chapter 1: a conceptual framework

Some examples of unsustainable financial practices
Example A. inflation of the financial sector via “securitization”
- Securitization = the design of new financial products (example: ETFs, options, etc.)
Example B. moral hazard problems in finance
Other examples: suggesting a shift to sustainable finance is needed
- Is GDP “growth” a sustainable goal?
o Doubling time & growth:
o A 10% growth rate means something doubles in size in ... y
o A 3% growth rate means something doubles in size in ...y
à If you double all goods and services, you double all externalities
à Doughnut Economy: the economy is an ‘ecology-like’ interdependent system that can only thrive
because of interconnected efforts. There is a ‘sweet spot’ keeping the balance between the social
foundation and ecological ceiling
Conceptual framework on sustainable finance
à The philosopher’s perspective: Two-level theoretical model (Joakim Sandberg)
Dominant view on the role of financial agents and markets = neoclassical economic theory:
“rational behaviour and utility maximization”
- Examples:
à Role of CEO/CFO = maximize shareholder value
à Role of portfolio manager = build highest risk-adjusted return portfolio
à Role of lender = maximize interest payments on loans minus default loss
à Role of financial consumer = maximizing income and/or minimizing costs
Underlying rationale = “division of moral labour”
- Comparative advantages when you focus on what you do best: specialization àproductivity à efficiency
o example: Industrial labour FORD-model
- Applied to Finance: financial MARKETS should create wealth & STATE should redistribute it. Cf. Body
with 2 arms (finance-arm & state-arm) functions best when two arms can do what they do best
Flaws of this dominant view have become apparent:
- 1. Collapse of the global financial system
o What is optimal on the individual level may be catastrophic on the collective level
o i.e. subprime lenders knew the risks but went for their bonus anyway
o i.e. banks knew capital reserves were inadequate but counted on the government to bail them out
- 2. Unable to address the great sustainability challenges
o Global poverty & climate change. ESG-externalities
o Cf. FINANCE arm does not seem to care about the body = justified according to the dominant view
Is more regulation and/or increased social responsibility the solution?
- A typical solution is more “regulation” for instance stress-testing, European supervisory mechanism; bazel
I, II, III and IV;…
o Push back costs onto individual agents to enforce a focus on sustainability
o Cf. state-arm keeps the finance arm on a leash
o = Not very sustainable: evading regulation (withholding info; finding loopholes; lobbying, etc.)
o = Not very effective (productivity via specialization is lost)
- Increased public awareness: Financial agents should accept more social responsibility.
o Cf. finance-arm SHOULD care about the body (i.e. stakeholder theory; CSR)
o Will all agents accept this or is it a utopian view?
o Again efficiency loss? Little room for “finance-arm to finance”
Towards a fundamental paradigm-shift: two-level model
- A philosophical model rooted in Kantian ethics and two-level utilitarianism (Hare, 1981). The model holds
the middle ground between the dominant view and contemporary calls for heavy regulation or far-reaching
social responsibilities.
- Goal= realize the neo-classical dream of ‘division of moral labour’ in a sustainable way
- Model:

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 o Division of labour under a common goal (= general aim of all agents). “For instance: a sustainable
flourishing society“
o But give all agents leeway to perform specific tasks that are useful under this general aim: agent-
specific aim
o So, agents continue to focus on their special aim under restrictions (1) they keep an eye on how the
special and general aim correlate and (2) take action when there are clashes between the two aims.
- Why would this model be better?
o Compared to dominant view: Agents now share a common goal of a “flourishing society” which
includes social and environmental sustainability
o Compared to heavy regulation view: More effective since the goal is now intrinsically motivated
rather than externally imposed.
o Compared to social responsibility view (CFR. Stakeholder theory): More effective because less
counting on the moral argument and more leeway for specialization and profit maximization
o Cf. Finance-arm can still do what it does best
- Implications for financial agents: two main challenges = “CLASHES”
o Exemplified by the financial crisis (subprime-lending; CDOs;…):
o à According to this model financial agents should refrain from practices that are systematically
detrimental to society. CFR. the ‘body’ will do fine if the finance-arm refrains from detrimental
financial acts.
o = feasible via growing ‘social licence to operate’-idea
o Exemplified by ESG-concern (global poverty and climate change):
§ Financial agents should take responsibility via positive action. For instance, devote considerable
resources to progressive companies without guarantee for a return or donate to non-profits
o = more problematic: will there be sufficient positive action? The societal body will NOT necessarily
be OK if finance-arm refrains from ‘unsustainable’ funding
- Implications for public policy and regulators:
o Regulators should support greater self-regulation. In addition, external regulation should be imposed
when needed (for instance for environmental issues).
o Reinterpretation or reformulation of ‘fiduciary duties’ among policy-makers, regulators, scholars and
institutions:
o Fiduciary duty = legal obligation of the ‘fiduciary’ to act in the best interest of another. It defines the
appropriate motivations of financial agents and should be directed more towards society.
à The economist’s perspective: An objective function approach (Dirk Schoenmaker)
Traditional finance focusses on finance only, ESG-externalities are typically NOT incorporated:
- à Sustainable finance studies the interaction between financial, social and environmental returns.
- Interaction naturally occurs via:
à Allocation: accelerate transitions to the sustainable economy via fund allocation.
Ie. Banks, investment funds.
à Investor influence and monitoring: steering companies via “shareholder influence”
Shareholder activism
à Risk pricing: improved asset valuation via risk pricing can help deal with inherent uncertainties for
instance related to climate change.
' '
max 𝐹𝑉 = 𝑓(𝑝𝑟𝑜𝑓𝑖𝑡, 𝑟𝑖𝑠𝑘) 𝑤ℎ𝑒𝑟𝑒 𝐹𝑉!"#$%& > 0 𝑎𝑛𝑑 𝐹𝑉"%() <0 (finance as usual)
Label Focus Maximization Timing
Finance-as-usual Shareholder value FV ST

' '
max 𝐹𝑉 = 𝑓(𝑝𝑟𝑜𝑓𝑖𝑡, 𝑟𝑖𝑠𝑘) 𝑤ℎ𝑒𝑟𝑒 𝐹𝑉!"#$%& > 0 𝑎𝑛𝑑 𝐹𝑉"%() < 𝑎𝑛𝑑 𝑆𝐸𝑉 ≥ 𝑆𝐸𝑉 *%+ (SF 1.0)
Label Focus Maximization Timing
SUSFIN 1.0 Refined value F > S and E ST

- A minimal threshold is set on Social and Environmental Value (=SEV):

à Exclusion: avoid investing in “sin stocks” or companies with “high negative externalities”
i.e. tobacco, weapons, oil companies, etc…
o Financial value is still the guiding principle through with these refinements i.e. the SEV side condition.
- A clear improvement but limited expected effects:
o Divestments in unsustainable assets by a growing number of investors might reduce stock prices and
increase funding costs. BUT other financing sources are still possible i.e. through retained earnings
and/or FIN-AS-USUAL investors
o Could lead to loss of license to operate and/or setting norms for acceptable standards

2
max 𝑇𝑉 = 𝑓(𝑝𝑟𝑜𝑓𝑖𝑡, 𝑟𝑖𝑠𝑘) (SF 2.0)
- Where 𝑇𝑉 = 𝐹𝑉 + 𝑆𝑉 ! + 𝐸𝑉 !
' '
and 𝑇𝑉 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 > 0 𝑎𝑛𝑑 𝑇𝑉 𝑟𝑖𝑠𝑘 < 0
.
and 𝑆𝐸𝑉&,- ≥ 𝑆𝐸𝑉&.
and p = privately discounted value
- Internalizing externalities: attaching a financial value to social and environmental impact
o = monetization of social and environmental impact
- Externalities become ‘priced’: i.e. carbon tax or effective future carbon price of $ 50-100 per tCO2e) and
thus the financial value of SE-intensive projects goes down.
- A private discount rate is used that properly incorporates all risks including social and environmental risks
i.e. higher discount rate for higher uncertainty related to S and E.
Powerful economic mechanism
- à Introduces a financial incentive for sustainable projects and penalty for unsustainable projects.
- à This may change the production process as more detrimental projects create lower value and may be
priced out of the market.
But main caveats:
- Monetizing ethical aspects is difficult:
- S and E play out the LT rather than ST making pricing hard (i.e. p can vary and is difficult to estimate)
- certain aspects hard to monetize. How to put a price on health, safety, human rights,…?
- F, S and E are in practice not substitutable: Large economic gains can offset S or E. In other words, this
approach can also legitimize destruction You can buy off negative S and E with high F
Label Focus Maximization Timing
SUSFIN 2.0 integrated value FV > F + S + E MT

max 𝑆𝐸𝑉 = 𝑆𝑉 + 𝐸𝑉 = 𝑓(𝑝𝑟𝑜𝑓𝑖𝑡, 𝑟𝑖𝑠𝑘) (SF 3.0)

& &
- Where 𝑆𝐸𝑉%*!/0& > 0 𝑎𝑛𝑑 𝑆𝐸𝑉"%() <0
*%+
and 𝐹𝑉&,- > 𝐹𝑉&,-
*%+
and 𝐹𝑉&,- = (1 + 𝑟 $/%" )𝐹𝑉&*%+
$/%"
and 𝐹𝑟 ≥ 0 𝑖𝑠 𝑎 𝑓𝑎𝑖𝑟 𝑜𝑛𝑒 − 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
- Finance is “meant to” foster sustainable development:
o Investing only in sustainable companies/projects
o Positive selection of projects that generate social and environmental impact
- Although not front-row, finance decision is still important to foster financial viability. If not financially
viable, projects will fail because of cash shortfall
o à i.e., puts finance back into its original goal?
- Obviously, the best sustainability outcome of all models.
- To have financially viable sustainable projects, investors should receive a FAIR return. Is this realistic?
o 59% of investors target risk-adjusted market-rate returns. Of the remainder, 25% target below-but
close to market-rate and 16% accept even lower return (=capital preservation).
o Great majority target market rate or close and small group accepts even lower for sustainability
reasons.
Label Focus Maximization Timing
SUSFIN 3.0 Common good value S+E>F LT

- Implied corporate governance theories

Finance-as-usual Shareholder value FV ST Agency theory
SF 1.0 Refined SV F > S and E ST Agency theory
SF 2.0 Integrated value TV = F + S + E MT Stakeholder
theory
SF 3.0 Common good S + E > F LT Legitimacy
value theory
o Corporate governance-theory implications
§ Finance-as-usual à “Agency theory”
§ SUSFIN1.0 à “Agency theory”
§ SUSFIN2.0 à “Stakeholder theory”
§ SUSFIN3.0 à “Legitimacy theory”
o Legitimacy theory indicates that corporates aim to legitimize their corporate actions to get approval
from society and thus to ensure their continuing existence
- Where are we in reality?

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 o The majority of financial institutions are currently at the SF 1.0 level
o About 30% to 40% are in between 1.0 and 2.0 thus adopting some sustainable principles but only
‘partially maximizing’ total value:
max 𝑉 = (1 − 𝛼)𝐹 + 𝛼𝑇𝑉 = (1 − 𝛼)𝐹 + 𝛼(𝐹 + 𝑆 + 𝐸) = 𝐹 + 𝛼(𝑆 + 𝐸)
with 𝛼 = 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑎𝑡 0.1
o Tiny share (< 1%) is adopting SUSF3.0
o Good/sufficient progress?
- Obstacles & guidelines
o Collective effort versus individual effort
§ Fallacy of composition: concluding something is true on the macro-level because it is true on
the microlevel (individual agents).
§ à Even if all externalities are properly internalized (=micro-level), it’s not certain that planetary
boundaries are not crossed (CFR. Sandberg!)
§ Boundary problem. Tightening of regulation in one sector leads to shifts to other sectors.
• i.e. sustainable investors divest in unsustainable financial assets. These become undervalued
and therefore become more interesting to other investors…
§ à ‘Adequate’ regulation is unavoidable (CFR. Sandberg!)
o Short-termism
§ Whereas S and E are felt in the longer run, the short-term horizon is the key feature of F.
§ à The reason is LIQUIDITY-function of finance.
§ Many examples of short-termism in finance:
• à Quarterly earnings reports, variable pay + stock options
• à “marking-to-market”: investors look at market reactions rather than at a fundamental value
• monthly benchmarks
• supervisory treatment aimed at ST: supervisory costs are much higher for illiquid
investments
• political horizon is ST
§ We should find a balance between markets as ‘disciplining devices’ and markets as ‘devices to
encourage proper behaviour’.
§ Moving from EMH to “adaptive markets hypothesis”.
• The degree of market efficiency (i.e. degree to which prices reflect info) depends on an
evolutionary model of individuals adapting to a changing environment.
• Distinct groups of investors are active in markets (i.e. hedge funds versus retail investors
versus market makers, versus institutional investors) that have a different investment horizon
and risk appetite. If they all competitive markets will be fairly efficient but if a certain group
dominates, it will be less efficient
• This explains why new risks are not fully priced since not enough investors are examining
those risks (hence an adaptive model).
o Aversion to change
§ The strong lobby of established companies
§ Human aversion to change
§ Lack of new frameworks to apply
§ à What’s needed is to stimulate the right changes via coalitions for sustainable finance
Applications/exercises
Ex 1. How practically applicable is the J. Sandberg model according to you?
à Look for a specific example of a “common goal” identified by stakeholders (countries, societies, industries,
companies, policy-makers,…) in any industry or field of expertise. Then look for underlying “agent-specific aims”
that have been formulated/executed by underlying agents.
- Innovation in most industries is key
à Do the agent-specific aims align well with the identified common goal? What actions have been taken to ensure
alignment? Can you observe any clashes between the two levels?
-
à Has this two-level model led to a redefinition of fiduciary duty and/or regulation?
-
à Use your insights to form an opinion about the practicality of the Sandberg model.
-
Ex 2. Apply the Schoenmaker-frame
à Consider in the table below a number of well-known financial decisions and/or financial practices that are
taken/conducted by financial agents.

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àReflect critically on these financial practices and describe the ‘finance-as-usual’ situation.
à Translate the ‘finance-as-usual’-practice into respectively a SUSFIN1.0-2.0-3.0-practice. In other words: what
would be the SUSFIN1.0-2.0 & 3.0 variant of the listed financial practice and why?
- Susfin 1 excludes bad bonds
- Susfin 2 selects ESG bonds
- Susfin 3 only selects green bonds

Ex 3. Are we making good ‘progress’ in the Schoenmaker-frame?

In the slides we’ve discussed (based on older data) that in terms of progression in the Schoenmaker-frame, we are
currently somewhere in between SUSFIN1.0 and SUSFIN2.0. But are we truly progressing in the different steps
towards 3.0?
à Can you find further recent evidence of FIN-AS-USUAL practices that are harmful to sustainability advances?
à Can you find further recent evidence of exclusion SUSFIN1.0-practices?
à Can you find further recent evidence of internalization SUSFIN2.0-practices?
à Can you find further recent evidence of common good value maximization SUSFIN3.0 -practices?
Based on your assessments, are we making (sufficient) progress in the frame?

Ex 4. Your turn to be offended

In the theory, we encountered several examples of unsustainable financial practices (notably inflation of the
financial sector and moral hazard) as well as recent trends that force us to further adopt sustainable financial
practices (notably climatological evolutions and unsustainable growth goals). But of course, there are many more
‘financial practices’ and financial evolutions you might consider/perceive as unsustainable.
à Consider one ‘financial practice’ you consider to be “unsustainable”. Analyse this practice in light of the
conceptual frameworks offered.
à What needs to happen, what changes or amendments are needed to make this financial practice more
‘sustainable’? How would you like to see this financial practice evolve?

13/10/2021

Chapter 2: Social enterprises

The value-maximization-paradigm (Jensen, 2001)
- Discussion on ‘purpose of the corporation’: what is the objective function of the firm?
- Should guide CFOs/CEOs in their corporate finance decisions
- Two main theories: shareholder theory versus stakeholder theory
o Both are explained
o Jensen argues shareholder theory is SUPERIOR to stakeholder theory
§ trade-offs between many objectives lead to managerial confusion
§ multiple objectives could lead to managerial self-interest
o He argues shareholder theory is NOT “at odds” with social welfare:
- enlightened shareholder theory: Maximizing the long-term market value of the firm DOES lead to catering
to the interests of all stakeholders

Shareholder theory:
Rooted in 200 years of economics and finance
∞
𝐹𝐶𝐹&
𝑚𝑎𝑥 𝑉$%"* = H
(1 + 𝑊𝐴𝐶𝐶)&
&2-
- The goal of the firm: maximizing the market value of the firm = maximizing the present value of future free
cash flows generated by the firm.
o It’s NOT maximizing the value of equity but the value of ALL outstanding financial claims (i.e. debt,
equity, warrants, preferred stock,…). So all financial claim holders should benefit.
o It’s in comparison to popular belief a LONG-RUN exercise. All future cash flows matter and are
“discounted” (reflects hurdle rate = price at which risk can be transferred in the market)
o So a good CEO is basically allocating resources with the goal to earn a financial return ‘in excess of
the opportunity cost of capital’
Rooted in sociology and organization behaviour
- Goal of the firm: balancing out interests of ALL stakeholders = individuals or groups who can substantially
affect or be affected by the welfare of the firm:
o ‘Financial claimants’

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 o But in addition ALSO employees, customers, communities and government:
§ 𝑉$%"* = 𝑓(𝑥, 𝑦, … ) = 𝑗𝑜𝑖𝑛𝑡 𝑜𝑏𝑗𝑒𝑐𝑡𝑖𝑣𝑒 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛
§ 𝑤ℎ𝑒𝑟𝑒 𝑥, 𝑦, … = 𝑣𝑎𝑙𝑢𝑒 − 𝑑𝑟𝑖𝑣𝑒𝑟𝑠 𝑜𝑓 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡 𝑠𝑡𝑎𝑘𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
Is shareholder theory superior?
- Multiple objectives is no objective:
o the problem of ‘serving many masters’
o Logically ‘impossible’ to maximize in more than 1 dimension. Cf. Math: No overall maximum exists,
only local maxima
o Advocates of stakeholder theory refuse to specify how to make necessary trade-offs:
§ 𝐼𝑓 𝑉$%"* = 𝑓(𝑥, 𝑦, … ) 𝑎𝑛𝑑 𝑠𝑡𝑎𝑘𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑚𝑎𝑦 ℎ𝑎𝑣𝑒 𝑐𝑜𝑛𝑓𝑙𝑖𝑐𝑡𝑛𝑔 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠:
34 ((&/)67#896" -) 34 ((&/)67#896" <)
§ 3;
>0& 3;
<0
- Vfirm is contingent on the current focus of the board of directors. Can range and vary from employment,
growth, output growth, current-year profits,…
o How can the CFO be held accountable for actions if no one knows what’s worse/better?
o The CFO is “value-seeking” rather than “value-maximizing.”
o This leads to managerial confusion: what should the CFO focus on?
o And potentially to managerial self-interest because he cannot be held accountable for any single
action
à Following Jensen it’s better to have a single-valued objective function: better to have one
encompassing goal rather than having multiple objectives where trade-offs are unknown.
- When firms maximize their long-term market value, the interests of all stakeholders including societal
interests are automatically catered to:
o A simple microeconomic logic: marginal benefits should exceed marginal costs:
§ A firm can only create added value when the output is valued higher than the input
§ therefore, the value to CUSTOMERS = GENERAL PUBLIC should be higher than the value of
SUPPLIERS
§ which means eventually production will provide what society ‘prefers’
o à You cannot build long-term benefits unless all stakeholders are on board. You need some kind of
strategy or VISION i.e. it should tap into some human desire or passion…
- Enlightened’ shareholder theory = maximize long-term financial value (one goal) but enlightened in the
sense that it’s backed by a vision/strategy to which stakeholders can agree. If you do this, it reconciles
stakeholder and shareholder theory.
o Main problem: This holds under the assumptions of:
§ No monopoly
§ No externalities: ‘third-party’ consequences
Introducing “externalities”: revision of the COASE-theorem
Externalities
- “cost or benefit on a third party not financially incorporated in the direct transaction underlying the third-
party consequence”
o Positive or negative externality (climate change)
o Private or public externality
- Externalities are prominent in the economic discipline: economists are trained to think in terms of
externalities:
o “Give me a one-handed economist!” US president Harry Truman
o cfr. Endogeneity in empirical research
§ 𝑦% = 𝛼 + 𝛽𝑥% + 𝛾𝑋%' + 𝜀%
Public externalities are increasingly problematic
- Environmental costs: global warming & climate change
- Socio-economic costs: poverty, economic exclusion “ESG-externalities”
- “Systemic risk”-costs: economic crises and shocks
- …
- Growing awareness that they should be taken into account:
o “ We only classify them as external for no better reason that we have made no provision for them in
economic theories”
o “ there are no side-effects, just effects”
o (H. Daley and J. Sterman quoted in Raworth: doughnut ECS pg143)
- Historical discussion on externalities:

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 o “no intervention needed” (lasser faire cfr. COASE THEOREM)

o “government interventions needed”

Coase theorem (Ronald Coase, 1960 – Nobel prize in 1991)
- “when there are conflicting property rights, bargaining between the parties involved will lead to an efficient
outcome regardless of which party is ultimately awarded the property rights, as long as the transaction costs
associated with bargaining are negligible”
- - Originally developed in the field of law as a conflict of “property rights”
o do you need a ‘judge’ to settle the conflict or let conflicting parties bargain?
- Later taken over in the field of economics
o Applied to “externalities” viewed as a conflict between producer and society
o Do you need government interventions to address externalities?
o Costs will be ‘absorbed’ in a negotiated equilibrium
- Example: NOISE-pollution by wind-turbines:
o Efficient to operate (shut down) turbine if the value of operating exceeds (is less than) noise cost.
o As long as parties can ‘bargain’ without costs, a bargained equilibrium can be achieved.
o For instance: if operating turbines is worth more to the company than ‘peace and quiet is worth to
households, there is a money offer that is acceptable to both parties.
o The allocation of property rights (through court for instance) has no influence on the outcome as long
as parties are free to negotiate.
à Basically says the free market can absorb all externality costs cfr. Adam Smith’s invisible hand
- Why would the Coase theorem NOT work?
o Valuation of externality-costs is difficult and inaccurate
o Elicited valuations depend on the initial allocation of property rights (=endowment-effect = different
power between the parties during the negotiations)
o Free negotiation or tied-up negotiations? parties involved, social conventions, bargaining costs,…
- Tension persists:
o “No intervention needed” “government intervention needed”
The social enterprise-concept
Social enterprise: market-based solution to externalities
- “No intervention needed” “government intervention needed”
Cfr. Coase-theorem
- What if we could create enterprises that:
o à Actively address a social, environmental and/or governance externality
o And thus have a double bottom-line: social goal (address the externality) and a financial goal (do this
in a financially sustainable way)
o we would have a market-based solution to actively reduce externalities
History lesson: introducing the concept “social business”
- The dream of M. Yunus: Social business
o à A social business promotes social objectives as primary while also making a profit.
o Investors do not receive a share of the profits via dividends, all profits are reinvested in the social
goal
o Social goal is primary but businesses should also be financially sustainable. So that the business can
grow and expand and the social goal is perpetuated/continued (going concern)
o It can therefore be best described as a non-dividend, non-loss company.
- 7 principles put forward:
o Maximizing a SOCIAL goal instead of maximizing profits
o Financial sustainability
o Investors can get the investment amount back
o All additional profits reinvested
o Environmentally conscious
o Workforce gets market wage and better conditions
o Do it with joy
Reflections on this model
- It is NOT non-profit (NGOs or NPOs) but profits are reinvested in the social goal. It is NOT charity as
investors can get their money back (even inflation-adjusted).
o à No dependency on (temporary) donations/subsidies
o à More focus on “going concern” so LT-oriented
o à More impact expected

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 - It is better aligned with human identity (=multidimensionally and altruistic versus single-dimension profit-
making machines)
- It should not be confused with CSR which are social initiatives WITHIN (typically) for-profit companies.
- This is a very “specific” model:
o Clear balance between social and financial goals: social goal dominates, financial serves the social
goal
o In that sense, it comes very close to the conceptual frameworks of Schoenmaker (SUSFIN 3.0) AND
Sandberg (encompassing goal)
- However, not ALL social enterprises are that well-specified:
o It’s therefore not identical to “social entrepreneurship” or “social enterprise models” which are more
umbrella terms covering all socially inspired ventures (including non-profit ventures or even not-
institutionalized ventures). Let’s call this the SE-MOVEMENT
o They all have a social and financial goal, but their balance is not always clear
Typology of broader SE-field (defourny and Nyssens, 2016)
- Typology according to 2 dimensions:
o Principles of interest (Gui, 1991). General
interest (=public) - Mutual interest
(=members) - Capital interest
(=shareholders)
o Funding/resource mix (Dees, 1996).
Dominant public- Hybrid – Dominant
market
- Observed evolutions:
o Red arrows = changes in funding
o Blue arrows = changes in principles of
interest
o Everyone goes more to the middle
1. Entrepreneurial non-profit model
o The whole non-profit movement. A social goal is pursued but they resort to the income/earnings
model.
2. Social cooperative model
o Cooperatives are member-based but not necessarily social. An increasing amount however aim for a
social goal i.e. renewable energy-coops; community-building coops
3. Social business model
o Yunus-type businesses. The social goal is prioritized but it should be financially sustainable.
4. Public sector social enterprise model
o Typically public sector spin-offs that have a social objective
à Common to all SEs is that they operate under a double-bottom line i.e. they balance out SOCIAL and
FINANCIAL objectives (aka HYBRID ENTERPRISES)
Empirical research on the double bottom line
- Not surprisingly the balance between social and financial objectives is one of the MAIN debated questions
in research. For instance: empirical research on MFIs
- 1. Is there a trade-off between social and financial objectives? (Hermes et al., 2011)
o Intuitively: The poorer the population, the smaller the loans which are more costly i.e. a higher cost
per dollar lent.
§ Compatibility view
• Increased financial efficiency leads to increased funding which may increase outreach to the
poor.
§ Trade-off view
• Outreach may conflict with financial sustainability as “cost per dollar lent” is higher when
servicing the poor
• à This paper offers an extensive empirical analysis to test the relation between outreach
(average loan size; % female clients) and efficiency (stochastic frontier analysis).
§ Stochastic Frontier Analysis SFA: how close is the actual cost of lending to the best-
practice/optimal cost (=technical efficiency frontier). The more distant, the less efficient and
vice versa.
•
• Cu = Actual cost you have
• C(…) = function with hypothetical numbers to determine the costs

8
 o à The further you are from the actual costs, the less efficient you are
• U = error term
§ = Cost-function: Total cost is a function of OUTPUT, INPUT-PRICES (salary, total loan
portfolio) and additional CONTROLS

§
§ ui,t measures how “far away you are” from the efficient cost-frontier and mi,t is the first moment
of the distribution.
• For a perfectly efficient MFI, mi,t = 0.
• à For a less than perfectly efficient MFI, mi,t > 0.

§ Then they regress the inefficiencies on typical OUTREACH variables: % female clients
(WOMAN) and average loan size (ALB).
• à δ1 and δ2 allow to test for the trade-off view versus the compatibility view.
• δ1 < 0 : bigger loans are more efficient
• δ2 > 0 : loans to female clients are less efficient
• à In support of trade-off
o Main result:
§ Larger loans is consistently and significantly associated with lower inefficiencies. More women
is consistently associated with higher inefficiencies.
§ In line with the TRADE-OFF view. It’s hard to combine increased social performance and
increased financial performance
- 2. Is the balance shifting? Fear of mission drift? (D’Espallier et al., 2017)
intro
o Mission drift: under the pressure of commercialization, there is a tendency to focus less on the poor
o We study 66 MFIs that have transformed from an NGO to a regulated bank over time.
à What happens after/because of transformation?
à We look at changes in a broad variety of “business-model” indicators:
o INCOME: portfolio yield
o COSTS: operational costs, funding costs, default costs
o FINANCIAL PERFORMANCE ROA, ROE, OSS
o Studying changes in the business model gives insights into whether there is a risk of MISSION DRIFT
i.e. a gradual focus away from the social mission.
o Event-study methodology:
§ Comparison between “observed values” (around the event= within event-window ) and “normal
values” (outside of event-window)
§ “Normal value” estimated in a “clean period” (i.e. when there was no sign of the event) via
underlying regression analysis:
§ 𝐴𝑉%,& = 𝑂𝑉%, &, 6>6+& − 𝑁𝑉 ] %, & “abnormal value” isolates the effect from the event
∑$ A4
§ 𝐶𝐴𝑉% = ∑?&2- 𝐴𝑉%,& ; 𝐴𝐴𝑉% = #%&? !,#
§ represent the cumulative and average abnormal value
o When MFIs transform from an NGO to a regulated bank, the business model changes:
§ We observe LOWER interest rates charged: Good for the clients, lower income for the bank
§ We observe LOWER operational costs: push towards efficiency
§ We observe a shift to a healthier funding structure of the bank: more debt-funding, funding via
deposits, lower donations
§ Overall profitability is STABLE and still relatively low.
• à ROA and OSS stable and low
• à Exception is ROE on the “longer” run: ABNORMAL values for ROE turn positive after
some years. We warn against shareholder-oriented mission drift in the longer run
- 3. Compatibility of hybrid goals? Ongoing work by PhD-student Eline Van der Auwera, WP
20/10/2021

A machine learning approach to uncover the ingredients in doing good in hybrid

organizations: evidence from microfinance (Eline Van der Auwera)
Hybrid organizations – social enterprises
- Multiple organizational logics

9
 o E.g. Hospital
- Social enterprises have the most extreme form of “hybridization”
o Financial and social goals
o Evolved from non-profit or spin-off multinational
o Fill up needs not fulfilled by “mainstream companies”
o Microfinance
Microfinance institutions
- Microfinance institutions are providers of financial services (like loans, insurance, …) to low-income
populations to aid them in becoming self-sufficient (Yunus et al. 2010)
- Social mission: help excluded populations in becoming self-sufficient = focus on the impact
- Financial mission: make a profit or be financially independent = focus on returns
Research questions
- Microfinance institutions can have different levels of social and financial performance. Among others, there
exists a group of MFIs that combine the best social and financial performance.
- The likelihood of harmonizing both goals depends on an identifiable combination and interaction of MFI-
and country-specific characteristics.
Identify the different clusters of financial and social performance
Dividing the cells into clusters: K-means
- The green cluster is the top performing cluster in both social and financial performance and contains
16,5% of the observations.
o Loan outstanding average per PPP: 196 Dollar
o 83% females in the loan portfolio
o 3-4 different loan types, 54% allows for a savings account and 48% offers other financial facilities
o Financial self-sustainability of 1,4 (>1 hence self-sustainable)
o ROA of 10,4%
Which underlying characteristics have an influence on the probability to be a double bottom line achiever?
- Method
o Out of 20 micro- and macroeconomic variables, we want to select those variables which have the
highest influence to correctly predict if an observation achieves top performance in both its social and
financial goal.
§ Feature selection (let the data speak!)
o Only 9 variables remain to predict correctly predict if an MFI is able to reconcile both goals, with
87.8% accuracy
§ Legal type, interest rate charged, an operational and financial risk measure, size, age, GDP per
capita and a political instability measure
- Effect of age and size
o MFIs should start small and grow over time.
o MFIs between 10-30 years old are the perfect combination of experience and avoiding mission drift.
o In general, a bigger MFI has a higher probability to be a double bottom line achiever.
o Countries with non-zero but low GDP per capita are most favourable.
o Higher debt/equity reduces the operational revenue because of default payments.
o A non-bank financial institution is less likely to harmonise the social and financial logic.
Conclusion
- It is possible to reconcile two different institutional logics.
- The country characteristics are important.
- A hybrid institution must uphold several characteristics to alleviate its probability to harmonize two
competing logics.
o Legal type is important
o Size plays a significant part
o The ideal age exists
o Hybrids must limit operational and financial risk
o Higher interest rates do not harm social performance

10
27/10/2021

Chapter 3: social financial intermediation

Banking functions (à)
- Transaction costs are prevalent in financial markets:

o banks can diversify

o banks realize economies of scale
o banks bundle expertise
à financial intermediation reduces transaction costs
- Asymmetric info is prevalent in financial markets:
o Adverse selection: bad credit risks most actively seek
out loans (ex-ante problem)
o Moral hazard: borrower engages in undesirable behaviour (ex-post problem)
à financial intermediation reduces asymmetric information problems
A well-known example of adverse selection: Akerlof’s lemon problem
- In a nutshell (based on second-hand car market):
o ‘Good’ versus ‘bad projects’ present in each economy
o Info asymmetries: investors unable to distinguish between the two
o Law in finance: “higher risk, higher required return”
o Since investors are unable to assess the risk: the required return for ‘good’ projects is too high
o Crowding out of the good projects: we are left with ‘bad projects’ i.e. lemons
- I.e. Also stock and bond markets have ‘lemons’. That’s why regulators, rating agencies, financial analysts,
etc are needed.
Banking-facts
- Stocks are not the main source of external finance for businesses
- Issuing marketable securities (debt and equity) is not the primary way in which businesses finance their
operations
- Indirect finance (= intermediated by financial institutions) is many times more important than direct finance
- Financial intermediaries are the most important source of external funds used to finance businesses
- The financial system is the most heavily regulated sector of the economy
- Only large, well-established companies have access to direct finance
- Collateral is a prevalent feature of debt-contracts
- Debt contracts are complicated legal documents that restrict borrower’s behaviour (=covenants)
The business of banking
- The traditional business model of banking is the provision of LT-loans funded by ST deposits:
o à maturity mismatch = assets are short term oriented and liabilities long-term
o à Assets & liabilities management (ALM) crucial
o à credits-spread: interest-spread between lending-rate and deposit-rate
o à fee-based business
- Loan losses occur in case of default and thus the contracted loan rate rc ≠ the expected loan rate rL:
o 1 + 𝒓𝑳 = 𝑬(1 + 𝒓𝒄 ) = (1 + 𝒓𝒄 ) ∗ (1 − 𝒑) + (1 + 𝒓𝒄 ) ∗ 𝒑 ∗ 𝜸
o with p = the default probability
o γ = the ‘recovery rate’ and (1- γ) the ‘loss given default’
o and 𝒍𝒐𝒔𝒔 = 𝑳 ∗ (𝟏 + 𝒓𝑪 ) ∗ 𝒑 ∗ (𝟏 − 𝜸)
o Example. rc= 6%; p=5%; γ=80% à what’s your expected loan rate? What are expected losses on a
€100 000 loan portfolio?
- The profit-function to maximize can thus be written as:
o 𝜋 = 𝐿 ∗ 𝑟E − 𝐷 ∗ 𝑟F + 𝐹 − 𝑒𝑥𝑝
Changed interest rate conditions
- Interest rate spread (lending minus deposit rate, %)
- WB development indicators
- à Despite efforts to diversify, net interest income still accounted for 58,9% of European banks’ total
income at the end of 2020.
- àTo achieve long-term profitability, European banks must shake off their dependence on net interest
income.
- Strong and diversified fee income, from areas such as
- capital markets, payments, insurance products, wealth management and trade finance, is one of the most
effective tools to offset net income pressure.

11
 - à Retail banking is under a lot of pressure… The banks cannot charge negative interest rates to clients
easily, so banks are leaving retail.
An inter-temporal maximization model
- Model settings:
o Two-period model
o Bank is a risk-adverse utility maximiser, freely setting interest-rate margins
o Pricing of loans and deposits
o RD = r – a
o RL = r + b
o S = rL – rD = a + b
o Where
o RD = return on deposits (paid)
o RL = returns on loans (received)
o S = spread of interest margin
o R = return in money market
o A,b = margins set by banks relative to money-market return
o

1. Competition in the market

a. More competition à more elastic demand for loans and supply of deposits à lower margins
b. More monopoly à higher margins
2. Average operating costs
a. Average operating costs associated with loans and deposits will translate in higher margins required

12
 3. Risk-aversion
a. More risk-averse banks will charge higher margins
4. Credit risk
a. The higher the credit risk, the higher margins charged by the bank to compensate for this extra risk
5. Volatility in the money market
a. When faced with volatile markets, banks will charge higher margins to compensate for this extra risk
6. Interaction between credit risk and interest rate risk
a. The more these risks reinforce one another, the higher the margins to compensate for this extra risk
7. Average size of the credit and deposit operations
a. The higher the size of the operations, the higher the margins
This results in S^ which can be considered to be a pure margin
à leaving the restricted setting of a utility-maximizing and accounting for other factors: institutional factors,
regulatory factors, etc..
8. Implicit interest rates
a. Sometimes “free” services are offered as an “implicit” extra remuneration for deposits
9. Opportunity cost of keeping reserves
a. Keeping cash reserves is costly because of the opportunity costs. The higher the cash reserves, the
higher interest margin is needed to account for these extra costs
10. Quality of management
a. Good management implies selecting highly profitable assets and low-cost liabilities, so a higher
margin is expected in case of good management
Towards sustainable financial intermediation:
A risk-based approach to sustainable lending
- = Incorporating ESG-externalities into the traditional banking model:
o cfr. SUSFIN 2.0: ‘enriching the model’= ‘pricing externalities’
o Integrating ‘sustainability criteria’ into the credit-risk analysis
o Acknowledging ESG-externalities are risk-factors that influence default probability p and loss gave
default (1-γ)
o According to Weber et al. (2010) introducing these risk factors will improve default predictions and
thus increase ban profits.
- Sustainability gains
o Incorporating ESG risk-factors into the credit-risk process increases the risk-premium charged to
unsustainable borrowers:
o This will lead to the ‘exclusion’ of certain unsustainable borrowers (cfr. SUSFIN1.0)
o And/or lead to more expensive borrowing for unsustainable borrowers via an extra risk premium
charged (cfr. SUSFIN2.0)
cfr. bank’s monitoring role
o In addition:
§ à This will ‘incentivize’ companies to address ESG-externalities resulting from their operations:
§ = Nudging theory
§ And they will get an overview of industry best practices and communicate those to prospective
borrowers cfr. Advising role
o “Banks play an accelerator role in the transition towards sustainability because asset allocation will
automatically shift towards more sustainable projects when higher risk premia are charged for ESG-
related risks”
The social finance movement
- A theory of social finance model by Cornée, Jegers and Szafarz
o Aim: conceptual understanding of the spectrum of social financial institutions (SFI) based on a unified
theory.
o Set-up: 2 players in a context of asymmetric info:
§ 1. Social funder (=motivated investor): ready to forego some degree of financial return in
exchange for social return
§ Example: pure donors, lenders, depositors, equity-holders
§ 2. SFI is a typical SE/hybrid in that it balances a social and financial mission. SFIs mission
consists in channelling capital from prosocial investors to their beneficiaries using efficient
selection and monitoring mechanisms.
o Are pro-social motivations realistic?
o Other-regarding preferences: “40% to 60% of individuals not only care for self-interest but also
exhibit concern for the well-being of othersӈ PURE altruism

13
o More selfish behaviour: image-based motivations and warm-glow; creation of social identity or self-
esteem à IMPURE or RELUCTANT altruism
o 1. Funder point view
§ 0 < R < Rm
§ Rm = risk–adjusted market rate
§ 𝑅 = 𝜌𝑅m, 0 < 𝜌 < 1 𝜌 𝑖𝑛𝑣𝑒𝑟𝑠𝑒𝑙𝑦 𝑐𝑎𝑝𝑡𝑢𝑟𝑒𝑠 𝑡h𝑒 𝑓𝑢𝑛𝑑𝑒𝑟’ 𝑠𝑎𝑐𝑟𝑖𝑓𝑖𝑐𝑒
§ 4 types of SFIs:

§ 1. Foundation 𝑅=0 ⇒𝜌=0

• Social investors require zero payback
-
§ 2. Non-profit SFI 0<𝑅<1 ⇒ 0 < 𝜌 < " '
• Social investors want to retrieve a part of their investment
-
§ 3. Hybrid SFI 1<𝑅<𝑅m ⇒ " ' < 𝜌 < 1
• Social investors require a below-market remuneration
§ 4. Commercial bank 𝑅=𝑅m ⇒𝜌=1
• Investors require a market-return
§ These types will co-exist and depend on funder’s sacrifice
§ The utility of the funder depends on the expected social contribution (SC) as well as the sacrifice
the funder is willing to make (ρ). Moreover, the expected social contribution depends in itself on
the funder sacrifice: 𝑈(𝑆𝐶, 𝜌)
3G 3G
§ Where 3(0 > 0; 3(H<0 𝑎𝑛𝑑 𝑆𝐶=𝑆𝐶(𝜌)
§ Different choices regarding the sacrifice the investor wants to make leads to co-existence of these
forms:
• 𝑈∗ = 𝑈(𝑆𝐶∗(𝜌∗), 𝜌∗)
§ For some investors: 𝜌∗ = 0 ⇒ 𝑈∗ = 𝑈(𝑆𝐶∗(0), 0) à they will prefer the foundation
§ For others: 𝜌∗ > 0 ⇒ 𝑈∗ = 𝑈(𝑆𝐶∗(𝜌∗), 𝜌∗)
-
• à If 0 < 𝜌∗ < I' à they will prefer the non-profit SFi
-
• à If I' <𝜌∗ <1 à they will prefer the hybrid SFi
o 2. CLIENTS POINT OF VIEW
§ What financial products will be offered to clients and what interest rates will be charged?
§ In a commercial bank:
• R = Rm the repayment requested for a dollar loan
• R > Rm exceeds the reward for funders because lending is costly and clients can
default
§ In an SFI:
• R = 𝛿Rm, 0 < 𝛿 < 1 The requested repayment is just a fraction of the market-rate. δ thus
inversely captures the discount offered clients
• If R=0 ⇒𝛿=0 you give a PURE GRANT
• If 0 < R < 1 ⇒ 0 < 𝛿 < Rm you deliver a negative-interest loan or a partial grant
• If 1 < R < Rm you deliver a positive but preferential loan = social bank
o Feasible combinations for 𝜌 and 𝛿
𝛿=0 𝟏 𝟏 𝛿=1
0<𝛿< 𝑹𝒎
<𝛿<1
𝑹𝒎
𝜌=0 Foundation
𝟏 Quasi-foundation Social bank
0< 𝜌< 𝑹𝒎
𝟏 Social bank
𝑹𝒎
<𝜌<1
𝜌=1 Commercial bank
§ !! Only these combinations are feasible:
§ line one. You offer zero return to funders. You cannot charge positive R to clients, you will not
maximize utility of your social funders.

14
 § line two: non-profit SFI. You offer some money back to funders. You cannot charge zero to
clients. You can either offer negative interest loans OR preferential loans. You cannot charge
full R to clients, you will not maximize utility.
§ line three: hybrid. You offer a below-market remuneration to funders. This is not possible if you
charge zero or offer negative interest loans, it will not be enough to pay funders. You cannot
charge full Rm to clients, the utility of investors will not be maximized.
§ à SFIs are all financial intermediaries in the social finance universe. What they have in common
is:
• A. founders make a smaller or bigger sacrifice in the sense that they do not get full market
return for their investment. Their return ranges from zero to below to positive but below
market
• B. clients will benefit in that they pay below market rates on the loan. Their repayment ranges
from 0 to below-market
à these SFI forms will co-exist because the sacrifice funders are willing to make differs
which shapes their utility-curve
No return to funders
Funders retrieve part of the investment and therefore no profit is required (= non-profit
SFI)
Funders retrieve a below-market return and therefore some profit is required (=hybrid
SFI)
à different loan products can be offered to clients:
Foundations give out pure grants to clients
Quasi-foundations give negative interest loans or partial grants to clients
Social banks give out preferential loans to clients
à there is a link between the profit orientation and products offered. The following
combinations exist:
If you offer zero return to investors, you are a foundation and you offer pure grants to clients.
If you are a non-profit making SFIs, you can either offer negative interest loans and thus be a
quasi-foundation or offer preferential loans and thus be a social bank
If you are a hybrid SFIs, you can only offer preferential loans and thus be a social bank
The business model of social banks
- Zooming in on the social banks: Offering preferential (=
below market) loans and can be organized as either non-profits
or hybrids.
- = Transforming the financial sacrifice of motivated/ socially
minded agents into affordable funding for credit-rationed and
informationally opaque social enterprises
- 𝐻1 ↔ 𝑟𝑒𝑡𝑢𝑟𝑛LM − 𝑟𝑒𝑡𝑢𝑟𝑛NM < 0
- 𝐻2 ↔ 𝑖𝑛𝑡. 𝑜𝑛 𝑙𝑜𝑎𝑛𝑠LM − 𝑖𝑛𝑡. 𝑜𝑛 𝑙𝑜𝑎𝑛𝑠NM < 0
- 𝐻3 ↔ 𝑖𝑛𝑡. 𝑜𝑛 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠LM − 𝑖𝑛𝑡. 𝑜𝑛 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠NM < 0
- Methodology:
- Comparative research SB and “comparable non-SB counterpart” using nearest-neighbour sample matching:
- à RE panel regressions: 𝑍%,O,& = 𝛼 + 𝛽- 𝑆𝐵%,O + 𝛽< 𝑋%,O,& + 𝛽P 𝑀O,& + 𝐶O + 𝑇& + 𝜀%,&
The business model of social banks: signalling social commitment
- 1. The ‘screening’ and ‘monitoring’ is different from commercial lending
- à For this model to work in a competitive credit market, funders need to be convinced that the social gain
compensates for their financial sacrifice i.e. there is no greenwashing. They need to be convinced about
the social quality of the projects and thus the social commitment of the social bank.
- à Because of the nature of the borrowers, social banks have to rely more on relationship lending:
- SEs are more informationally opaque, more soft information via intensive ‘relationship’ is needed.
- Evaluating social aspects of projects involves a soft component
RQ. How do social banks signal a social commitment to motivating funders?
- à Two channels were investigated:
o Selectivity. Proxy = deposit-to-assets ratio: Selective lending via intense relationships requires
inelastic funding via depositors more than market-based commercial funding
o Transparency. Proxies = interest-income to total income ratio and loan-minus deposits ratio. You
want to rely less on complex financial products and want to ensure a tight link between deposits and
loans.
- Main findings summarized:

15
 o àIn line with expectation, social banks have a higher deposit-to-assets ratio and a higher interest
income to total income ratio
o à This supports signalling social commitment via selectivity and transparency
o à However, there is a weaker link between deposits and loans measured by the deposit-minus-loans
to total assets ratio:
o This may suggest a problem of excess liquidity due to selective lending
o Tough social screening can restrain a bank’s ability to transform deposits into loans.
o Subsequent excess liquidity might be the Achilles heel of the SB model.
The business model of social banks: reciprocity
- 2. But the selective lending process pays off...
- Remember: The social banking model transforms funder’s sacrifice into affordable funding for social
borrowers. The screening needs to be ‘selective’ and ‘transparent’. But:
- à social borrowers respond to advantageous credit terms by lowering the default rate
The business model of social banks: additional research
- This is an example of “reciprocity” in the credit market”: A phenomenon whereby borrowers who
consider themselves fairly treated by the credit institution need no enforcement devices (incentives,
monitoring,…) to swiftly repay their debt.
- Why does this happen? Social identity seems to be a driving force of this observed reciprocity: “ an
individual’s sense of self, derived from perceived membership of a relevant social group” (Chen and Li,
2009)
- à Social identification with ‘lender’ reduces moral hazard
- à This reciprocity is an interesting mechanism to solve ‘moral hazard’-problems originating from
informational asymmetries
- à It can ‘substitute’ for relationship’-lending which has also been shown to reduce moral hazard but takes
time to develop and effort to maintain.
cfr. Sandberg-model in CH1: the “common social” goal as a way to overcome problems in the credit
market
Applications/exercises (solution will be posted online)
Ex. 1. Revisit the “microeconomic” banking model by Maudos and De Guevera (2004)
à who are the main actors/agents in the model? What is the objective function? What are the main decision
variables? What are parameters that can be influenced in order to make decisions?
- Bank, maximize utility, a and b, parameter = s
à what are the main assumptions underlying the model? Are these realistic assumptions?
- The bank setting utility, not realistic, they also must obey regulations
- Only 2 periods, in reality, it is a going concern
à does this model approach reality? Is this a complete model? What is missing? Which model extension would
bring the model closer to reality?
-

EX. 2. Revisit the macro-economic social finance universe model by Corneé et al. (WP)
à who are the main actors/agents in the model? What is the objective function? What are the main decision
variables? What are parameters that can be influenced in order to make decisions?
à what are the main assumptions underlying the model? Are these realistic assumptions?
à does this model approach reality? Is this a complete model? What is missing? Which model extensions would
bring the model closer to reality?
03/11/2021

Chapter 4: Sustainable financial markets

How efficient are financial markets?
Revisiting the efficient market hypothesis
Start of the EMH: random walk theory
- à The movement of stock prices does NOT reflect any pattern: RANDOM WALK THEORY
EMH
- Such a random walk can only be explained if markets quickly absorb/incorporate new information:
- “EMH: Prices are a reflection of available information and thus fundamental value”
- Reasoning:
- If past prices could be used to predict future prices, there would be arbitrage opportunities (risk-free
return opportunities)

16
 - Typical for finance: arbitrage-opportunities disappear immediately
- Prices must reflect existing information and markets quickly absorb new information
- 3 forms of EMH:
o Weak Form Efficiency. Market prices reflect all historical market-information
o Semi-Strong Form Efficiency. Market prices reflect all (past and current) publicly available
information
o Strong Form Efficiency. Market prices reflect all information, even inside or private information
EMH: simple logic, huge discussions
- Strong-form is unlikely. Insider trading would not exist and/or be prosecuted
- Weak or semi-strong or not efficient at all? Under debate
o See for instance discussion on active versus passive investment funds
o See for instance discussion on regulation vs. deregulation of financial markets
EMH consensus?
- Most economists would agree:
- That markets are ‘somewhat’ (=weak / semi-strong) efficient and that in the long-run prices thus reflect
fundamental value
à but at the same time many anomalies exist:
o January-effect
o Home bias
o Disposition effect
o Bubbles and crises
o Herding
Rationality or irrationality?
- “The market can remain irrational longer than you can remain solvent”
- “Just because markets are unpredictable, it does not mean that they are efficient”
- “ Just because some individuals might be irrational, it does not mean the market is inefficient”
More realistic alternatives
1. Adaptive market
- In some markets it seems as if EMH should be replaced by ‘adaptive markets hypothesis’:
- à In the AMH-logic, actions ‘can be taken to ensure a more transparent (= more honest/fundamental) price
in financial markets:
o increased market participation or access to financial markets
o avoid domination/monopoly of a certain group of investors
o increased information flows in financial markets. Aim = to better inform market participants so all
proper risks are incorporated
- Shift to a more LT-oriented view on financial markets:
- EMH: emphasizes liquidity-function of markets à markets as “disciplining devices”
- AMH: emphasizes LT fundamental price à markets as “vehicles to encourage proper behaviour”
- à Note that the AMH, much like the EMH, provides a RATIONAL explanation of market prices.
Irrationalities of agents are not part of the price explanation.
New types of market participants pouring in
- Activist investors
- New “millennial-traders”: crypto/meme-stocks/gamification…
2. Behavioural markets
- Can we explain observed market anomalies by introducing “irrational behaviour”?
- à Insights from psychology/sociology to explain irrational behaviour
- à“ finance from a broader social science perspective including psychology and sociology”
- à Influence of emotions, personality and social interactions on financial decision-making
- à Special interest on INDIVIDUAL behaviour versus MARKET-behaviour
Different “behavioural biases” observed
- A bias is an unconscious mental activity that produces inclination towards error
- àCognitive bias: processing information incorrectly
o Estimation error
o Anchoring o Excessive optimism o Confirmation bias
o Over-confidence o Familiarity bias
o Conservatism o Misattribution bias
- à Emotional bias: making inconsistent decisions based on feelings
o Herding behaviour o Prospect theory
o Mental accounting o Regret avoidance
Main issue: does the individual bias distort the market?

17
 Efficient market hypothesis Behavioural finance
1 Individuals
Behave Mainly rational Not fully rational
Make decisions based on All available information Limited information
What about rationally? Individuals can be irrational Individuals are irrational
à but this is non-systemic / à this is systemic/relevant for the overall
irrelevant for the overall market market
2 Markets
Quickly incorporate all relevant Quickly absorb all info AND the
information and absorb individual predictable irrational behaviour
irrationalities
à so that prices reflect fundamental à so that prices reflect in the long-run
information fundamental info
à but irrational behaviour can dominate
and be anticipated
à Research plays at the intersection between studying INDIVIDUALS and MARKETS
Illustration: behavioural corporate finance
- Corporate finance aims to explain financial contracts (= financing decision) and real investment behaviour
(=investment decision) that emerge from the interaction of financial managers and investors.

- à Managers can take for granted that financial markets are somewhat efficient (EFM) and prices reflect
fundamental value
- à Investors can take for granted that managers will rationally respond to incentives shaped by
compensation plans, the market for corporate control and corporate governance
- Behavioural corporate finance replaces this
assumption and allows both investors and managers to
act irrationally
o Irrational investors approach.
Investors/financial markets are irrational, and
managers are rational
§ Mispricing happens in financial markets.
Managers will exploit these deviations from
fundamental value because of their superior
information.
§ They ACT on the mispricing by balancing 3 objectives:
• Maximizing fundamental value (traditional view)
• Maximizing current share price (catering view)
• Exploit temporary mispricing’s by issuing equity when over-valued and repurchasing equity
when under-valued (market-timing view)
§ Managerial objective function
• 𝑀𝐴𝑋Q, 6 𝜆[𝑓(𝐾) − 𝐾 + 𝑒𝛿(. )] + (1 − 𝜆)𝛿(. |
• With:
• 𝑓(𝐾) − 𝐾 value-creation via new investment K with f(K) being concave and increasing in K
• 𝛿(. ) represents all catering-activities a manager can do to exploit mispricing’s i.e. give an
interview, give an unexpected dividend, change name, manage earnings,…
• 𝑒𝛿(. ) representing market-timing activities = selling (repurchasing) equity when over-valued
(under-valued)
• 𝜆 = [0,1] represents the time-horizon of the manager exogenously determined by personal
characteristics, compensation contracts
o λ=0 à manager cares only about ST
o λ=1 à manager cares only about LT
§ observed corporate financing decision: real
Investments in Electronics (’59-62); growth stocks (’67- = catering to investor appetite
bubbles 68); high-tech & bio-tech (‘80s); dot.com
(late ‘90s-early 00s)

18
 Concentration orDiversification comes in waves ie;. = catering to investor appetite
diversification conglomerates popular in ‘60s
(diversification premium) but unpopular
in ‘80s (diversification discount)
M&A is timed Over-valued stock used to engage in = exploiting mispricing of
share-for-share M&A (=ill-advised your stock
acquisitions)
§ observed corporate financing decision: Financing
Equity Over (under)valuation is an important = exploiting mispricing of
issuance/repurchase motive for equity issuance (repurchase): your stock
is timed - 86% agree they repurchase stock when
over-valued and buy back when under-
valued
- reinforced by issuing banks who get the
underwriter fee.
Cross-border issues Companies sometimes sell shares abroad = exploiting cross-border
and/or in several countries mispricing and home-bias
Debt issuance is Issue and renegotiate debt when interest = exploiting interest rate
timed rates are low conditions set by regulators
and financial market appetite
Market-timed The firm’s capital structure is the = exploiting mispricing and
capital structure outcome of incremental market-timed interest rate conditions
issues of debt and equity
§ observed corporate financing decisions: Other
Catering theory of Dividends used as signalling devices to signal = influence investor
dividends positive returns perceptions
Earnings Earnings are inflated using creative accounting = influence investor
management perceptions
Executive Managers get stock-option plans and have an = catering to investor
compensations incentive to cater to investor appetite appetite
Name-giving Companies changed names to get abnormal returns = catering to investor
during dot.com Alpha microsystems à alphaserv.com appetite
(20/01/1999)
Asset retrieval à Creditgroup.com (01/02/1999)

o Irrational manager approach. Managers make irrational decisions and investors are rational
§ Financial markets are somewhat efficient but managerial behavioural deviates from rationality:
• Can be ‘bounded rationality’ (managers think they act rational), or any other psychological
bias
• Context of ‘limited governance’ and ‘hubris’
§ Managers WANT to maximize fundamental value but are too optimistic about the prospects and
therefore maximize ‘perceived’ fundamental value
§ Managerial objective function
• 𝑀𝐴𝑋Q,6 (1 + 𝛾)𝑓(𝐾) − 𝐾 − 𝑒𝛾𝑓(𝐾|
• With:
• (1 + 𝛾)𝑓(𝐾) − 𝐾 Representing the ‘perceived’ value-creation from a new investment K.f(K)
is concave and increasing in K and now increased with an OPTIMISM parameter ϒ
• 𝑒𝛾𝑓(𝐾) Representing ‘perceived’ loss from issuing equity. The optimistic manager always
believes the stock is under-valued and therefore it is never a good moment to issue equity
• 𝛾 An “optimism-parameter”, exogenously determined by managerial characteristics and/or
the managerial environment
§ Observed corporate financing decisions: Real
Excess optimism in At start-up 66% of entrepreneurs believe their = excessively
corporate venture will be more successful than optimistic managers
investment comparable ventures. In reality around half
decisions survive 3 years
In mature firms’ investment projects are
almost always severely under-budgeted
(energy, construction, etc.)

19
 M&A synergy In the pre M&A process values from = excessively
values over-stated synergies get over-stated. optimistic managers
Regularly followed by good-will write offs

§ Observed corporate financing decisions: Financing

IPO under Typically shares are issued at a lower than = hubris/over-
pricing intrinsic value therefore rises considerably on confident managers
day.
Managers are not concerned with this ‘money left
on the table’ because they believe the intrinsic
value is even higher
In their eyes, this windfall GAIN outweighs costs
of under pricing
Pecking order Equity issued only at LAST resort because it’s = hubris/over-
theory (POH) never a good time to issue equity if you think confident managers
stock is permanently under-valued
Contracting with VCs stipulate they can intervene when they = hubris/over-
optimists observe excessive optimism/hubris confident managers
observed Too much risky ST debt contracts are taken up
by over-confident managers. They have a hard
time integrating out their past behaviour.

o To conclude
§ Two streams of literature with different NORMATIVE implications:
§ IRRATIONAL INVESTORS: To avoid anomalies, managers should be ‘shielded’ from
pressure from irrational markets.
§ IRRATIONAL MANAGERS: To avoid anomalies, managerial discretion should be reduced.
§ A lot on the table:
• Under debate: further understand the behaviour of irrational investors, irrational managers
and implications for corporate financing decisions.
• How do we build a combined model: irrational investors and irrational managers?
3. The “financial instability” hypothesis
- ‘Equilibrium-thinking’ is dominant in financial theories:
o Fundamental value is discounted value of future cash flow
o Prices on financial markets reflect the intersection of intrinsic demand and intrinsic supply
- In practice: financial markets are dynamic systems:
- à Hyman Minski (1975): financial instability hypothesis: “stability breeds instability”
- Reinforcing feedback loops
o i.e. In boom periods banks, firms and borrowers gain confidence causing asset prices to rise
o Rising asset prices reinforce borrower and lender confidence creating a further rise
o Etc...
à speculative investment booms
- Followed by a Minsky Moment:
o When prices no longer reflect fundamental value
o An inevitable ‘tipping point’ is reached: sudden price correction is the result
o Now followed by NEGATIVE feedback loops:
à The result is PERMANENT or INHERENT instability from bust to boom
o Example. Subprime lending in US housing market
- Understanding financial markets as “dynamic systems with built-in reinforcing feedback loops”:
- à dis-equilibrium pricing theory (Keen & Standish; Betz): Tracking the price-path in a financial market
using a disequilibrium model that considers taking into feedbacks by banks & borrowers
- à Cfr. The economy as an ecology-like interconnected system where we need to monitor the “TIPPING
POINTS” instead of emphasizing the fundamental price
- à Recognize that SYSTEMIC risk is an important factor to consider
Sources of systemic risk
Exam: what is the difference between systemic and systematic risk
A theory frame
1. Theory frame on systemic risk: Benoit et al., 2017, ROF
- Set up

20
 o N institutions with risk exposure xi
o Part is systematic risk; rest is idiosyncratic risk:
o 𝑦%( = 𝑎% 𝑥%
o 𝑦%8 = (1 − 𝑎% )𝑥%
o à Cumulative risk exposure for all institutions: 𝑦 ( = ∑%R2- 𝑦%(
o Institutions have direct links among each other (interbank loans; derivatives on each other
o financial assets, etc.):
o B = (N x N) matrix whose elements bi,j, denote how much i is exposed to j
Theory frame systemic risk
- Risk and Return. Returns will be affected by risks taken:
o Returns on systematic factors: 𝑝 ( + 𝜀 (
o Returns on idiosyncratic factors: 𝑝% + 𝜀 %
§ The returns are shocked, the 𝜀 stands for the shock
o Where ps and pi are constants and 𝜀 ( and 𝜀 % are independently distributed random variables with zero
mean (shocks)
- Benchmark pay-off of institution i in case of no other financial institutions:
o
o for instance in a CAPM-frame:
§ pi = profit
§ y = exposure to
§ rho (p) = pay off
§ 𝜀 = shock
o Meaning:
à In the absence of other institutions, the pay-off of institution, i is a function of its risk exposure to
the systematic shock, its idiosyncratic risk exposure and the return shocks associated with these
exposures.
àSince all institutions are exposed to the systematic factor, they can all suffer losses simultaneously
simply because a large negative shock occurs. We call this systematic risk.
- Actual pay-off of institution i differs from the benchmark pay-off when i belongs to a system of institutions.
The actual pay-off also depends on the exposures of other institutions, the idiosyncratic shocks they face
and links between i and other institutions:
o
§ B = how you are linked to other companies
o Where:
§ ys = (N × 1) vector of systematic exposures
§ yl =(N × 1) vector of idiosyncratic exposures
§ 𝜀 % = (N × 1) vector of idiosyncratic shocks
§ and B and 𝜀 ( still defined as above representing all linkages between institutions and the
systematic shock affecting all institutions simultaneously.
- Key take-away here is that
àThe fact that institution i is part of an interconnected system does affect the pay-off of i
- beyond the benchmark-situation that already included the systematic shocks to all.
- Systemic risk is thus “broader” than systematic risk.
- àSystemic risk can be viewed as a joint statement about i.e. the determinants of the joint distribution of

2. Three main economic mechanisms leading to systemic risk

a. Systemic risk-taking mechanisms: work via xi and ai
- Tries to explain the distribution of and in the system. Why do individual institutions choose to be exposed
to similar risks (high ) and take large risk exposures (high ). This increases systemic risk in the system.
b. Contagion mechanisms: work via linkages-matrix B
- When a single institution suffers a loss from an idiosyncratic shock, other institutions will also be affected
via the linkages leading to lower . In other words, the payoffs of two institutions are correlated even when
there is no systematic shock:
-
c. Amplification mechanisms: work via ys
- A small shock can turn into large losses
- For instance, a small negative shock 𝜀 ( to all institutions may affect all institutions with large leading to
asset selloffs exerting a price impact to all market participants.

21
 - - It depends on the cumulative exposure of all institutions to the shock 𝑦 ( i.e. the effect of a systematic
shock will be larger when cumulative exposure 𝑦 ( is larger

-
3. Summarizing figure

Different sources of systemic risk

Identified systemic risk sources: systemic risk-taking
1. Systemic risk-taking
1.1. Correlated investments. Financial institutions often invest in the same assets
- à When one bank fails, the overall level of risky investments in the markets is reduced, causing lower
profits for surviving banks. To minimize this externality, there is an incentive “to fail or survive together”
(Acharya, 2001; Acharya, 2009).
- àWhen banks fail, they fail together ensuring a “too-many-to-fail” bail-out guarantee from governments
(Acharya and Yorulmazer, 2008)
1.2. Liquidity risk. Banks invest too much in illiquid assets
- àFree-rider problem: if a bank experiences sudden liquidity re drawal, they will borrow on the interbank
market from the most liquid banks. You, therefore, count on the ‘others’ to hold liquid assets (Bhattacharya
and Gale, 1987)
1.3. Tail risk. Banks invest in assets with a ‘low probability of failure but when it fails, the losses are huge.
- àTail risk assets are rarely observed and thus not adequately priced and/or regulated. So regulatory
arbitrage and/or investors failing to adequately price in huge losses may turn banks into such tail-risk assets
(Perotti et al., 2011).
1.4. Leverage cycles and bubbles. Banks undergo the same cycle of leveraging and deleveraging.
- àFrom a macro-economic perspective, there are obvious links between business cycles and financial
cycles. For instance: “pro-cyclical leverage” because investors are more optimistic in an expansion phase
thus willing to take more risks (Bhattacharya et al., 2011).
2. Contagion
2.1. Balance sheet contagion and networks. Many examples of interbank claims on the
- balance sheets and the formation of bank clusters.
- àInterbank markets have advantages (risk-sharing) but at the same time lead to contagion (Allen and Gale,
2000).
- àBanking networks are ‘robust yet fragile’ (Eisenberg and Noe, 2001)
2.2. Payment and clearing infrastructures. Banks make regular payments to each other as a result of their
client’ s operations.

22
 - àNet positions are settled at the end of the day which allows keeping less cash reserves but at the same
time makes banks dependent on the same interbank market (Freixas and Parigi, 1998).
- àThe interbank markets clearing system is vulnerable to disruptions (Afonso and Shin, 2011).
2.3. Informational contagion. Depositors and investors tend to mix information on different banks
- àBank returns are correlated which can trigger banking panic (Chen, 1999). àCross-deposits can cause
depositors to redraw from bank i if problems arise in bank j.
- (Dasgupta, 2004).
3. Amplification
3.1. Liquidity-driven crises. Liquidity crises are self-reinforcing.
- àWhen market prices drop, banks need to liquidate assets to meet funding and collateral constraints,
reinforcing price drops (Plantin et al. 2008).
- àMargin requirements tend to increase when markets become less liquid, reinforcing the search for
liquidity causing a “margin spiral” (Brunnermeiere and Pedersen, 2009).
3.2. Market freezes. Several financial markets can quickly freeze up and/or break down àInterbank markets
have proven very fragile during the 2008 crisis because of informational
- asymmetries and mistrust (Heider et al., 2015).
- àBut also other markets such as REPO-markets because of unreliable fundamental value calculations
(Gortin and Ordonez, 2014).
3.3. Coordination failures and bank runs. Banks are inherently fragile because of coordination problems of
their creditors (investors and depositors).
- àBank runs are amply documented (Freixas and Rochet, 2008).
- àBut also financial market runs occur frequently where market participants quickly liquidate positions out
of fear of sell-offs and depressed prices (Lagunoff and Schreft, 2001).
Applications/exercises

17/11/2021

Chapter 5 Financial inclusion

Unlimited access to financial markets? (à)
CAPM: Required assumption: Unlimited borrowing and lending
at the risk-free rate of return
Recognized by UN-policy
- End poverty in all its forms everywhere
- Promote sustained, inclusive and sustainable economic
growth, full and productive employment and decent work for all
What do the data tell us?
- Financial access is more problematic for poor
- Financial access is more problematic for women
- Financial access is more problematic for young
- Differences in usage of the accounts
- Informal versus formal financial economy
- A cash versus digital financial economy
- Financial resilience remains fragile
The microfinance promise: banking the “unbankable”
Micro-lending is offering small-scale loans to financially excluded:
à Without collateral: group-lending and joint liability
à Stepping-stone theory: frequent instalments, sequential, small loans
à Mainly targeting women
à close to /within communities
à Opposite of conventional banks
Grameen bank success story:
- From $27 loans for 42 people …. to 9 million borrowers, 97% women and 26 million USD dispersed
Triggered a billion-dollar “microfinance-industry” of MFIs specializing in micro-lending:
- For example: in 2016 in India alone: 47 million borrowers and 15 billion in outstanding loans
- Double-bottom line institutions as an example of broader social enterprises
The rise of microfinance …
- Some 10 years ago considered the wholly grail in development:

23
 o Unlock entrepreneurial potential so they can “lift themselves” out of poverty
… quickly turned into the fall of microfinance
- From 2010 onwards, everything changed…
- “Grameen bank is sucking blood from poor people” (prime minister Bangladesh Sheikh Hasina)
- “ Yunus should have been given the Nobel price of Banking” (Heineman)
- “microfinance is antagonistic to economic development” (Bateman)
- “We cannot all be Bill Gates” (Dichter)
Observed externalities
Consumption versus entrepreneurship
- Most MF-loans are used for consumption, not for productive investments…
- Yunus-view - Bateman-view
- All human beings are born entrepreneurs, - Microloans give everyone the opportunity
but poor people lack the confidence to start a business BUT many are
- Microcredit opens door to limitless self- subsistence entrepreneurs
employment - Small informal businesses, not profitable &
- Used for starting or expanding income- many fail
generating activities - Many don’t want to grow business, use the
- More successful borrowers create revenue for consumption
employment for the poorest individuals - Loans are not enough to finance substantive
- Borrowers lift themselves & others out of growth, increase in employment, investments
poverty by expanding business in technology, etc
- Loans do not lead to economic growth or
reduction in poverty
- Microfinance is antagonistic to economic
development
Over-indebtedness and coercive enforcement
- Over-indebtedness:
o Many MFIs are “one-legged” credit-institutions
o Loans and DEBT are two sides of the same
coin
o Multiple lending is wide-spread
- Coercive enforcement
o On the loan-officer level: incentive
mechanisms can lead to bad LO-behaviour
o i.e. Grameen 5-star system for branches:
perfect repayment required
o On the group level: individual default
triggers group default
- Microlending can lead to vicious cycles of
over-indebtedness:
- Example of multiple lending (à)
Commercialization and mission drift
- Commercialization
o The huge untapped market potential of the unbanked has led to rapid expansion
o Both UPSCALING and DOWNSCALING observed
o This leads to large heterogeneity in MF-providers: NGOs, NBFIs, shareholder banks, COOPs,….
o A growing pool of socially oriented investors (MIVs) is shifting ‘asset allocation’ in the markets

- Mission drift
o This may challenge the double bottom-line: outreach vs. financial sustainability
o This may cause a shift from the ultra-poor, to less poor, to richer clients
- Commercialization: example

24
 o Compartamos banco

o BlueOrchard Impact investment managers

o Are these examples of commercial success stories or the failure of the microfinance model?
- Mission drift: ongoing academic discussion
o Difficult to define and measure mission-drift:
§ measuring the financial part of the bottom-line is straightforward: OSS, FSS, ROA and ROE
§ measuring the social part is difficult: % female clients, % rural clients, # clients, AVGloans
o Average loan size (scaled by per capita GNI):
§ Proxy for the depth of outreach.
§ But arguably a ‘very rough’ proxy:
§ cross-subsidization on the MFI-level
§ rolling-over smaller loans
§ demand-driven and context-specific
Interest rate morality
- High-interest rates are typically observed in microlending: Is this exploitation of poor lenders or does
it naturally reflect high transaction costs, high risks and short instalments?

o Microlending is an example of ‘periodic discounting’

- A weekly interest rate of 1% amounts to an effective annual interest rate of 67%.
o We should be looking at the price of the loan in comparison with the ‘income’ of the loan:
- Returns from petty-trade are on average 847% on an annual basis (100 USD investment generates 847
USD income) thus largely exceeding the cost of the price micro borrowers face
- What are ethical interest rates, what are usury interest rates?
o Hudon and Sandberg (2011): an ethical rate strikes a balance between the interests of institutions and
clients.
- How should regulators deal with this? Hard-caps / soft-caps / no-caps?
o Zetsche and Dewi (2018): since 2010 some 40 developing countries-imposed caps. They strongly
advocate against hard-caps: hard-caps do not account for differences in business conditions and will
increase the informal sector and trigger mission drift. Instead, competition should be stimulated to lower
interest rates.
Impact of microfinance
- RCTs as the panacea for economists
- RCTs are unquestionably the most scientifically valid research strategy but two major weaknesses:
- External validity & economics as a behavioural science
- Regarding micro-finance, a whole wide range of impact is observed from RCTs:
o +: business growth, HH-income, consumption, empowerment, education
o -: disempowerment, only expenditures go up, increased violence
- Careful consensus?!
o Rigorous quantitative evidence on the nature, magnitude and balance of microfinance impact is
inconclusive (Armendáriz de Aghion and Morduch 2005, 2010).
o Most economists would agree the impact of micro-lending is limited at best
o More positive impact observed for micro-savings
o MF is not the “magic cure” for a “disease” called poverty.
Repayment crises
- Microfinance has shown to be resilient to macro-economic shocks…
o Muhammed Yunus (August 2008) : “in the middle of all the bad news, microfinance still works”

25
 o Bill Clinton (October 2008): “Investors should consider the poor of developing nations as viable
investment alternatives to today’s volatile markets.”
o “These tests suggest that microfinance portfolios have high resilience to economic shocks.” (World
Bank)
- But strategic defaults are ‘contagious’ and may pose a systemic risk:
o Crises observed in India, Morocco, Nicaragua, Bosnia, Mexico
o NO PAGO movement
Changing views
The following all contribute to the inclusive financial system
- Systemic or 360° view
- Digitization
- Product-development
- Microfinance PLUS
- Regulatory environment
Practioner’s view
Illustration self-regulation: SPTF universal standards (à)
Illustration self-regulation: CPPs and SMART-certification

Illustration self-regulation: SP management tools

The role of cooperatives

Vijah Mahajan (CEO BASIX):“ Are we really going to leave this beautiful concept in the hands of value-
maximizing share-holder owned entities”
2 opposing views:
- SH-entities shift the balance to financial sustainability and not cater to the needs of the poor.
- SH-entities are more efficient in their governance and therefore services are more “scalable” thus leading
to more outreach.
Cooperative activity in the field
- Different cooperative organizational forms observed:

26
 o Member-based credit unions (SACCOs)
o VICOBA’s
- But mainly unobserved grass-roots associations: Savings-groups
The SG-operational model in a nutshell (à)
- Grass-roots cooperative financial ventures existing for
centuries
- Often facilitated by development agencies (CARE-
model/SILC-model/...)
- Not formalized but well-organized:
codebook/chairman/cash-box 3 locks/personal S&L
pass-book/etc...
- Weekly meetings: savings & lending
o Savings-constrained members put in small
amounts every week
o Optional take out of loans dependent on saved
amounts
o Yearly cycles and yearly share-outs
- Economic model: restricted financial value on group-
level
o The financial value created on group-level is restricted via interests on the loans
o possibly complemented with small-scale IGAs (fines; some group-level activities...)
- But a lot of social and financial value on the individual/member level:
o Financial inclusion of previously excluded members: a tool for cash flow management
o The upside potential of external opportunities outside the groups creates individual financial value =
leverage-effect
o Insurance component: social fund in case of death/emergency
o PLUS-services: additional development activities i.e. literacy, business skills, health care
Do cooperatives better cater to the needs of the poor?
- Univariate statistics indicate less emphasis on the financial side
- As well as more favourable interest rates
Relation with the formal banking sector: Périlleux et al. 2016
- Cooperatives have lower outreach in terms of members and institutions where the formal banking sector is
more developed
- Cooperatives mobilize more savings where formal banking infrastructure is in place
08/12/2021

Chapter 6 SUSFIN methodologies

Integration of ESG ratings into valuation
Understanding ESG ratings
Definitions
- ESG rating is a scoring framework via which a publicly listed or privately held company, sector or country’s
performance on ESG factors is evaluated and measured in a systematic way to yield a combined ESG score
for that company, sector or country.
- ESG index is an investable index calculated by aggregating the individual company scores assessed for the
ESG performance of each constituent in the cohort of companies to form the index.
Obvious tool for SUSFIN-advances: FIN-AS-USUAL – SUSFIN1.0 – SUSFIN2.0 – SUSFIN3.0
- Portfolio management: stock & bond-valuations
- Financial intermediation: risk-based approach to sustainable lending; social banking
- …
à All requires “trustworthy” assessment of ESG performance
Growing influence
- Assets Under Management (AUM) using ESG-scores estimated to have increased from 4 trillion USD to
60 trillion USD in 2016 (growth rate of around 35%)
- Global Initiative for Sustainability Ratings (GISR) estimated 39 rating products and 121 ESG indexes
- Main providers:
- MSCI, Dow Jones, Thompson Reuters (US)
- Sustainalytics (Netherlands)
- FTSE (UK)

27
Challenges related to ESG ratings
Challenge 1. Black box on methods and definitions
- 1. From ‘negative screening’ to ‘best-in-class’ approaches
o Depart from ‘bad practices’ or from ‘best-practices’
- 2. ‘Uniformization/standardization’ vs. ‘context-specific factors’
o A one-size-fits-all rating allows for comparison and standardization of what in essence what the
financial agents need. But context-specific factors matter.
- 3. Backward vs. forward-looking
o Mostly on self-reported past performance, doesn’t take into account future efforts
o i.e. BP was removed from DJSI World Index only after deepwater horizon tragedy in 2010
o i.e. VW was removed from DJSI World Index only aftermarket capitalization fell because of emissions
fraud in 2015
- 4. Biases towards where “demand” is and where “available data” is
o Geographical bias towards developed economies
o Firm size bias towards large companies
- 5. Quality of information differs a lot and is key
o A mix of quantitative and qualitative factors probably preferred
o Including confidential information is probably preferred
Challenge 2. Low correlations thus low comparability
Challenge 3 weak link between valuation and ESG-Scores
- àWe expect a positive association between the ESG-scores and financial value:
- Ceteris paribus: higher ESG performance/lower ESG externalities – lower risks – lower discount rate –
higher valuation
- à It’s difficult to assert empirically:
o Early empirical studies mostly found lower portfolio valuations
o Huge meta-study of 2000 empirical studies and review studies in the 1970-2014 period: 90% of studies
find a nonnegative ESG-CFP relation.
Opportunities of ESG ratings
- 1. Activism by investment managers
o Investment managers put ESG-pressure on investee companies, but also on stock exchanges to
increase standardized reporting on ESG
- 2. Thematic investing
o Develop investment ‘themes’ around various dimensions of ESG-scores such as gender diversity;
labour rights; etc...
- 3. Impact investing through ESG
o “Positive selection” on ESG scores to select projects that benefit society. May allow for below-market
financial return as a financial sacrifice
- 4. Effects on corporations and their managers
o Corporate managers do seem to pay attention to their ESG ratings:
o à Reputation concerns (brand loyalty etc...)
o à They fear scrutiny by institutional investors, regulators and consumers
o i.e. realize they can no longer push externalities onto society.
o à Searching for WIN-WIN situations between societal benefit and financial value
Sustainability advances in portfolio management
current practices
FIN-AS-USUAL situation:
- Active portfolio managers believe they can outperform the market by selecting securities that generate
higher returns.

28
 - Passive portfolio managers don’t believe that they can outperform the market by selecting superior
securities and thus follow a diversified INDEX.
- Cfr. theoretical underpinning: EMH- discussion
à Both approaches want the highest risk-adjusted return portfolio
à Little or no societal allocation role for investments
à Investments are interchangeable and short-term oriented
- Leads to the following type of analysis (see excel calculations)
conditions for long-term value creation (à)
- 1. Long investment horizons
o period and take the sustainability of the business model into account.
- 2. Active management of a concentrated portfolio
o integrated analysis on a ‘limited number’ of financial assets
- 3. Effective engagement
o (meetings with the company, voting in the annual meeting,…)
- 4. Performance management
o Performance measured through added value in real economy i.e.
both F, S, E-value
- 5. Long term alignment of mandates
o Asset managers and clients (owners) should have a long run and
aligned mandates and incentives should be set accordingly.
- 6. Keeping investment chain SHORT
o Informational distance between players in the investment chain (asset owner, asset manager,
corporation) should be limited in order not to lose valuable information
Dealing with uncertainty in corporate valuation
Standard approach (à)
- Ceteris paribus-assumption:
- à Is “one-shot valuation”: assumes the firm’s FCFs are ‘certain’ and
can be predicted ‘ex-ante’
- Ignores reality of “changing conditions” for the firm
- Ignores uncertainty related to the pricing of externalities
Corporate valuation: standard approach
- In reality: ceteris NON-paribus
o The impact of ESG-externalities becomes increasingly important:
o i.e. climate change risks regulation; stochastic carbon price; demand-shifts; reputation; etc.
- Bianchine and Gianfrate (2017): Estimated direct exposure = 3%-12%; indirect exposure = 40%-54%
à We need to incorporate uncertainties in our valuations.
- Adjusting the cost of capital/ WACC to reflect risks reflected to ESG externalities
- Adjusting the DCF method to incorporate uncertainties:
o ‘Scenario-testing’ or ‘weighted DCF’
o ‘Real options’
Impact on the cost of capital/wacc: positive
-
-
- Treating carbon risk as a non-diversifiable/systematic risk
o
o à Massari et al. (2016): 𝛽%,NS< between 0,03-0,06
o à Estimates vary but it’s clear that expected “equity risk premium” for carbon is positive leading to
higher expected equity returns à thus higher WACCs à thus lower valuations for carbon-intensive
projects and companies (cfr. STRANDED ASSETS)

29
scenario testing and weighted DCF
- Example 1. Energy company (à)
o Bianchine and Gianfrate (2018). Climate risks and the practice
of corporate valuation. In research handbook of finance and
sustainability. Pg 446
o Assumptions. WACC = 5%; expected inflation = 0%; cash
flows = EBITDA; price per MWh constant (unable to pass on
higher price to customers)
- Example 2. Mining company
o Schoenmaker, D and Schramade, W. Principles of Sustainable
Finance. pg. 143-144
o Assumptions: a mining company with a 1.1-billion-dollar
market value has a production process that is fresh-water
intensive and operates in a water-stressed area. Continuing
using freshwater threatens the loss of the (social) licence to operate from 2021. It could build a
‘desalination plant’ so as to use abundantly available seawater. This is a costly procedure (requires
2-billion-dollar investments, 20 million yearly investment and 15 million operating costs) which
doesn’t add to the CFs of the company. WACC = 10%; perpetual growth = 2%.
o Should the mining company invest in this?
§ FIN-AS-USUAL situation
§ Considering required (social) license to operate

- Example 3. Oil company

o Schoenmaker, D and Schramade, W. Principles of Sustainable Finance. pg. 64-66
o Assumptions: An oil company has a current stock price of $126 and the price of oil is currently $60
(per barrel crude). What is the effect of introducing a “carbon price” on the stock price of the
company? Carbon prices are introduced in varying degrees of speed and shock.
o Business as a usual scenario: no “carbon price”
o à 3 different scenarios of the introduction of a carbon price:
§ Early gradual transition from 2020 onwards allows the company to adapt operations towards
green energy
§ Late but more radical transition from 2030 giving no time to adapt operations towards green
energy
§ Middle-ground scenario: transition from 2025 giving “some” possibilities to adapt operations
to green energy
o à Only in the business-as-usual scenario, the current share price is justified. In every carbon scenario,
the current stock price is over-valued and could even fall to zero (bankruptcy) in the late scenario=
STRANDED ASSET
o 1. Attaching a probability to each scenario
§ The “risk” of a carbon price introduction is NOT priced in on the financial market. In fact, the
risk is (126-93)/126 = 26% undervalued at the current share price of 126.
o 2. What probability distribution justifies the current market price of $126
§ The market “prices in” that there would be a 60% chance of a business-as-usual scenario and
around a 13-14% chance of each of the other scenarios. If you believe 60% chance of the business
as usual is an overestimation, then the stock price is over-valued.
- SEE EXCEL CALCULATIONS

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Real options
Introducing real options
- à A real option is the right to re-evaluate and adjust capital budgeting decisions as new business
information comes in
- à The presence of such real options ADDS financial value to the investment project
- Real options are more valuable in a context of higher uncertainty:
o 𝐶 = 𝑆 × 𝑁(𝑑- ) − 𝑃𝑉(𝐾) × 𝑁(𝑑< )
)
TU [ ] X√?
*+(-)
o 𝑑- = X√?
+ <
; 𝑑< = 𝑑- − 𝜎√𝑇
- Cfr. Financial option: you “trade on” the uncertainty à higher levels of uncertainty make options more
valuable
Analytical tool: decision tree analysis
- à A graphical representation of future decisions and uncertainty solutions.
- Helps gain insights into:
o the nature of the uncertainty
o the type of real options you have along the way: wait/abandon/scale-up
o these are typically related to the uncertainty ahead
- à Information-nodes and decision-nodes
Example 1. Meghan on the flea market
- Berk, J. and DeMarzo, P. Corporate finance second edition. Pg. 738-
747
- Example
o Flea market booth reservation costs $500
o Good weather (75%): profit = $1500
o Bad weather (25%): -$100
o No time-value of money
- Solution
o Naive approach? (à)

o Real-option approach? (à)

§ She takes the option to WAIT and ‘only’ goes when the
weather is good

§ Advantage: if the weather is bad, she stays home and

avoids losing $100.

Example 2. Fashion designer: OPTION TO EXPAND (à)

- Berk, J. and DeMarzo, P. Corporate finance second edition. Pg. 750-752
- Example:
o $ 10 million investment today to produce clothes
o If successful: 1 million FCFs in perpetuity
o If not: nothing
o Production is flexible: project can be doubled on same terms
o P(success) = 50%
o Cost of capital = 6% (TVM)
- Naive approach?

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 - Real-option approach? (à)
o Real-option approach? Double the size of the project
on original terms at any time
o
1
𝑁𝑃𝑉𝑑𝑜𝑢𝑏𝑙𝑒 ,𝑡=1 = −10 + = 6.667 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0.06
(0.50 ∗ 6.667)
𝑁𝑃𝑉𝑑𝑜𝑢𝑏𝑙𝑒 ,𝑡=0 = = 3.145
1.06
𝑁𝑃𝑉𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑤𝑖𝑡ℎ 𝑜𝑝𝑡𝑖𝑜𝑛 = −1.667 + 3.145 = 1.478 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
-
Example 3. FOOD STORE: OPTION TO EXPAND
- Berk, J. and DeMarzo, P. Corporate finance second
edition. Pg. 752-754
- Example
o $ 400k today to open the new story in a new area
o Lease-payments on store = 10k/month.
o The lease contract can be cancelled after 2 years
o Either new area becomes “trendy” : 16k/month revenue
o Either area remains “normal”: 8k/month revenue
o P(success) = 50%
o Cost of capital = 7% (TVM)
- Naive approach? (à)
o Operate regardless of area popularity

- Real-option approach? (à)

o Cancel lease & walk away after two years if store is not
successful
16 − 10
𝑁𝑃𝑉𝑠𝑢𝑐𝑐𝑒𝑠 = −400 + = $661 947
0.00565
1 1
𝑁𝑃𝑉𝑓𝑎𝑖𝑙 = −400 + −2000 ∗ ; − < = −$ 444 770
0.00565 0.00565 ∗ 1.0056524
𝑁𝑃𝑉𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑤𝑖𝑡 ℎ 𝑜𝑝𝑡𝑖𝑜𝑛 = 0.5 ∗ 661947 + 0.5 ∗ −444771 = $108 589

Tips and tricks for managers

- 1. Think about including a real option = identify where the
uncertainty lies
o à Meghan: weather?
o Fashion designer: design appealing?
o Food store. trendy area?
- 2. Design strategies to optimally exploit contingencies = introduce interim decision-moments after
uncertainties have materialized
o Meghan: stay home if the weather is bad
o Fashion designer. Double investment if the design is appealing
o Food store. Walk away if the not trendy area
- 3. Rework your NPV. You will have created a valuable real option that adds substantially financial value
to your project:
o Meghan: NPV increase from $600 to $625 (value option to wait = $25)
o Fashion designer. NPV increase from -$1,66 million to $1.478 million (value option to double =
$3.145 million)
o Food store. NPV increase from - $46 018 to $108 589 (value option to abandon = $154 607)
Guest lecture: Triodos
Still supports greenhouse gas-producing firms but limits this
Wants to have a net 0 by 2035
Recently more regulation to avoid greenwashing à however a limited number of restrictions on the polluting
companies

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